Question

A company has an outstanding one-year bank loan of $500,000 at a state interest rate of 8 percent. The company is required to maintain a 20 percent compensating balance in its checking accounting. The company would maintain a zero balance in this account if the requirement did not exist. What is the effective interest rate of this loan?

A. 8 percent
B. 10 percent
C. 20 percent
D. 28 percent

Answer 1

The effective interest rate of this loan is 10%.

Step-by-step explanation:

The effective interest rate of this loan can be calculated by dividing the interest expense by the net loan amount. The net loan amount is the loan amount minus the compensating balance. In this case, the loan amount is $500,000 and the compensating balance is 20% of the loan amount, which is $100,000. Therefore, the net loan amount is $500,000 - $100,000 = $400,000.

The interest expense is calculated by multiplying the loan amount by the interest rate. In this case, the interest rate is 8%, so the interest expense is $500,000 * 8% = $40,000.

Now, we can calculate the effective interest rate by dividing the interest expense by the net loan amount: $40,000 / $400,000 = 0.1, or 10%.

Therefore, the effective interest rate of this loan is 10% (option B).